Amazon’s Fundamentals are Getting Worse

One of the most successful fundamental hedge-fund portfolio managers, Roberto Mignone of Bridger Management, once said, “When a position moves against you, don’t panic. Research.” The more I research Amazon, contrary to the recent price movement in the stock, the more I find the fundamentals are getting worse.

From Microsoft’s $605 million life-line to Barnes & Noble’s Nook business to new developments in state sales tax collection to even the temporary margin improvement in the Q1 quarter to the recent and future launches of low cost Android 4.0 (Samsung/Google/ASUS) and Apple iOS tablet competitors; all point to a weaker long-term fundamental positioning of the company.

Microsoft Giving $605 million to Barnes & Noble’s Nook Business is Bad for Amazon

Before today if you told me to give you top 5 list of news events that would be most detrimental to the fundamentals of Amazon, Barnes & Noble getting a deep pocketed strategic partner for its Nook business would have been number 2 on that list.1

And that is exactly what happened with the news of Microsoft’s investment agreement with Barnes & Noble. If you read the SEC 8-K filing [Link], you will find Microsoft is paying $300 million for a 17.6% stake of the NewCo business (digital Nook business+College bookstore business) and an additional $305 million over the next 3-5 years for revenue sharing and technology development.

The consensus was Barnes & Noble without a strategic backer would be bankrupt within 1-2 years and be especially vulnerable to a “scorched earth” ebook price war from Amazon with the “agency” pricing model likely going away as a result of the recent DOJ actions against the publishers and Apple.

What was Amazon’s biggest legitimate opportunity to win back digital media market-share by driving Barnes & Noble out of business is now a lost cause as Nook will have the dry powder to match any price war and develop new products to compete for several years. In fact if Amazon does lower prices, all it will do is lower profit margins for all the players in the market.

One of the most interesting competitive developments in the last 2 years is on a “level pricing playing field” Barnes & Noble has been able gain significant market-share in the ebook business by out executing Amazon and simply making better products.

The company went from 0% ebook market-share to 27% in 2 years, while Amazon went from above 90% to 60%.

”Amazon is going to have a tough time holding on to the 90 percent share of the e-book market it currently claims.” Source: CNET 2/17/10 [Link]

”Mr. Lynch said Barnes & Noble now held about 27 percent of the market, a number that publishers confirm gleefully. Amazon has at least 60 percent” Source: NYTimes 1/28/12 [Link]

Amazon ironically became what Microsoft was to Apple, a lame copy-cat of Barnes & Noble’s superior engineering.

In November 2010, Barnes & Noble launched the Nook Color [launch review Link], the first successful low-cost color IPS screen tablet with a forked Android OS. It did so well that Amazon basically had to copy the device with the Kindle Fire launch in November 2011.

In June 2011, Barnes & Noble launched the Nook Simple Touch with its revolutionary infrared beam touch screen technology. It won great reviews [Link] and Amazon quickly copied it with the Kindle Touch in November 2011, finally giving up Jeff Bezos’ decree that all Kindles must have physical keyboards due to the verdict of the market-place.

And this month Barnes & Noble launched the Simple Touch GlowLight [launch review Link], which Amazon will surely copy in the months ahead. Do you see a pattern here?

The clear take-away is against a fully funded Nook business, hardware engineering innovation, prime position as the digital book-store of Windows 8 operating system, and simply being a maker of “better products,” Amazon will have a tough time re-gaining market share in the ebook business against Barnes & Noble, not even mentioning the Apple iPad iBooks store and the ramping digital self-publishing book eco-system of Apple’s iBooks Author [Link], which enables authors to create multi-media ebooks with ease.

1My number 1 on the Top 5 “bad for Amazon” list is the launch of a low cost $249-299 7-inch Apple iPad, which will probably happen later this year.

New Developments in State Sales Tax Collection

Last Friday Amazon announced [Link] it will start collecting state sales taxes in Texas starting July 1st, 2012 as a settlement of dispute from last September. This is a new near-term development. Amazon is already slated to collect sales taxes in the big states of California and Pennsylvania in September 2012 [Link] with many more states looking to legislate in the coming year. It’s only a matter of time before Amazon will lose its state sales tax non-collection advantage across the whole country.

Texas, California, and Pennsylvania alone are 24% of the U.S. population that Amazon will be forced to collect state taxes in the next 5 months. This will raise effective pricing by at least 6-8% for Amazon customers in those states. Econ 101 tells us if a company raises effective pricing 6-8%, it will hurt sales.

On the last earnings call, Amazon’s CFO was asked directly by a sell-side analyst TWICE on whether starting to collect state sales tax in New York State slowed sales. The CFO conveniently would not comment on “any specific geography” like New York State, but repeated the same refrain from the past that for 50% of Amazon’s sales the company collected some kind of VAT tax (Europe) or sales tax and the company was able to grow in the past few years.

No-one is saying Amazon will stop growing as it starts collecting state sales taxes in more states, but there is no doubt in my mind it will hurt sales growth. Common sense tells me if a customer has to pay 6-8% more for a product, maybe he or she would be willing to pick up the product at Walmart or Target later in the day vs. waiting 2 to 5 days to get the product delivered through the mail if the pricing delta is smaller.

If a customer is ordering electronics and lives in Texas, on a level sales tax playing field, ordering from Dell.com which is based in Texas suddenly becomes a much more competitive option, along with the potential for quicker local warehouse shipping. The same can be said for NewEgg.com customers in California or B&H Photo [www.bhphoto.com] and J&R [www.jr.com] customers in New York State, all solid reputable online retailers that get a new lease on life to compete for their local in-state customers. To say 6-8% effective increase pricing won’t impact sales growth for these reasons above, doesn’t pass the common sense test.

It’s All about the Kindle Fire and the Fundamental Prospects are Still Poor

Last week Amazon reported Q1-12 financial results. Sales growth decelerated 100bps from Q4 from 35% y/y to 34% y/y in Q1. The company guided Q2 revenue growth to 27% y/y at the mid-point of guidance, which would be 700bps of deceleration. Operating income was –40% y/y and Electronics+General Merchandise business decelerated from 48% y/y growth in Q4 to 43% y/y in Q1.

On the positive side, World-wide media segment accelerated from 15% y/y growth in Q4 to 19% y/y in Q1. Gross margins also improved 120bps y/y from 22.8% in Q1-11 to 24% in Q2-11.

As this table from Amazon’s 10Q clearly shows all the profitability came from the North American business and the International business’ margins plummeted even further.

There are two drivers to the better margins in the North American business.

1) I believe for the first time in the history of Amazon, the company decided to NOT delight customers and raise prices 50-100% on select items in their Subscribe & Save business. This customer message board [Link] is filled with these pricing examples through-out Q1-12.

Also during Q1-12 I noticed Amazon adopted the Gamestop’s shady practice of increasing videogame prices significantly couple days before a “Buy 2 Get 1 Free” sales promotion.

The simple fact is raising prices 50-100% on customers who have subscriptions isn’t likely to lead to long-term margin improvement. There will be a short-term lag as customers see the higher pricing on their credit card bills and cancel their subscriptions.

2) The second more important driver of better margin was digital media purchases by new Amazon Kindle Fire owners [Note: Kindle Fire was only released in North America]. By triangulating data-points, I estimate Amazon sold 5 million Kindle Fires in Q4-2011.2 Please read my previous article [Link] for reasons why the Kindle Fire sold well initially.

I did a survey of 10 Kindle Fire owners and asked them how many ebooks they bought in the first 3 months of ownership. The average was 3.4 ebooks. Using a blended average of $9.99 and $12.99 ebook prices from Amazon’s Kindle store I calculate an $11.49 ASP X 3.4 ebooks sold X 5 million Kindle Fires = $195 million of additional digital media revenue. That number nicely coincides with the upside in the media business vs. street expectations. Ebooks are also high margin as there is little to no cost other than bandwidth.

So the Kindle Fire is driving digital media sales and improving margins, that’s great news right? Not so fast.

In my same survey of 10 Kindle Fire owners, I asked them how many ebooks they intend to buy in months 4-6 after ownership. The average was 1.3 ebooks. The take-away is after a Kindle Fire owner first purchases the tablet, they populate it with a few ebooks in the first 3 months, but additional purchases taper off afterwards. That would be fine and dandy if Kindle Fire sold like the iPad quarter-after-quarter (Apple sold 15.4 million iPads in Q4-11 and 11.8 million iPads in Q1-12), but all the data-points show Kindle Fire sales slowed dramatically in Q1-12. I estimate Kindle Fire sold a paltry 1-1.5 million units in Q1-12.2 Again read my previous article [Link] for reasons why Kindle Fire sales slowed.

Since Amazon takes a loss on every Fire sold, the irony is drastically lower Kindle Fire sales in Q1-12 also helped Amazon’s North America margins in Q1-12.

For the reasons given above, over-extrapolating Q1-12 y/y margin improvement as something sustainable is fool’s gold as it is dependent on the continued sales success of the Kindle Fire.

Furthermore all the arguments I laid out in my March Amazon article – “Kindle Fire Conundrum” section [read it again – Link] on the weak current and future competitive positioning of the Kindle Fire are equally valid, if not more so today.

In addition to the $199-$249 7-inch Google/ASUS Android 4.0 OS tablet which is slated to come out in July and the 7-inch Apple iPad which will probably come out in the Fall, a surprising entrant I did not realize a few weeks ago is Samsung. Samsung already released 7-inch Android 4.0 $249 Kindle Fire killer on April 22, 2012.

2 I estimate Kindle Fire sold 5 million units in Q4-11 and 1-1.5 million units in Q1-12 triangulating from the following data-points:

-Digitimes on 2/20/12 reported Kindle Fire shipments in Q1 fell to 1.5 million units.
-Taiwanese Economic News on 3/27/12 reported Amazon moved 5 million units in 2011 [Link]
-Texas Instruments mid-quarter conference call on 3/8/12 comments regarding new product Q4 OMAP product launch which was clearly the Kindle Fire: “customers are now rationalizing both their expectations for ongoing demand as well as the associated inventory”-Supply chain checks from Pacific Crest and OTR show 75-90% q/q decline in component orders for Kindle devices
-Pro-rating USA Today Kindle Fire to iPad app download numbers comes out to 5-6 million Kindle Fire units [Link]
-Pro-rating ComScore’s recent 1 Kindle Fire to 10 iPad in use ratio also comes out to 6 million units if you take account some run-off in iPad 1 devices.
-Frequent sales for used Kindle Fires from Amazon at $139-179 and even Best Buy at $150 speaks ill of the demand and the return rate. Walmart also had $50 gift card sales promotion
-Barnes & Noble on a 2/21/12 conference call said their largest competitor (obviously the Kindle Fire) had a return rate of 15-25%

You write: The CFO conveniently would not comment on “any specific geography” like New York State, but repeated the same refrain from the past that for 50% of Amazon’s sales the company collected some kind of VAT tax (Europe) or sales tax and the company was able to grow in the past few
years.”

But its VAT practices in Europe for digital goods are coming under scrutiny..
http://www.guardian.co.uk/technology/2012/apr/04/amazon-british-operation-corporation-tax

“..Amazon’s tax issues extend beyond the U.S.: British
authorities are investigating why Amazon’s Luxembourg-basedmEuro subsidiary paid no taxes on its 2011 U.K. sales, which totaled over $5.3B. It’s added Amazon’s U.K. ops paid less than $5M in taxes from 2003-2011, and that its corporate structure allows it to charge a VAT of just 3% on local
e-book sales, rather than the 20% charged by British rivals.”

http://fulfillmentcenters.com/ Service fulfillment

Just because MS is throwing their clout to Barnes and Noble doesn’t necessarily mean a huge impact on Amazon. Don’t forget that B&N doesn’t have anywhere NEAR the fanatical devotions that Amazon customers have.